The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Monday, May 6, 2013

LIke Ireland, Spain's bad bank good for bankers and disaster for taxpayers

As predicted by your humble blogger when Spain first began talking about setting up a bad bank to hold the bad loans in its banking system, the result has been good for bankers and a disaster for taxpayers.

The prediction was easy to make because Spain didn't require that the banks provide transparency before taking on the bad debts.

With disclosure of the individual exposures, markets could have valued these exposures and the taxpayer supported bad bank could have acquired them at market prices. The banks that originated the loans would have been forced to take the losses on these loans.

Instead, the bad bank acquired the toxic debt at prices that were favorable to the selling banks. One can only imagine the size of the bonuses that have been paid out to the bankers that should instead have been used to pay for the losses on the bad debt.

Spain's bill to bail out its banks may yet rise, some bankers and analysts fear, as a worsening economy hampers the government's early attempts to sell off nationalized lenders and threatens the "bad bank" housing their rotten property deals.

Spanish banks say the worst is behind them after steep losses last year and they are now recovering - a view broadly shared by authorities such as the European Commission, backer of a 41 billion euro ($54 billion) rescue of ailing lenders.

But while Madrid is on schedule with demanded industry reforms and banks are better protected against losses from a sunken real estate market, a growing number of bankers argue in private that more state funds may still be needed to help sell rescued lenders and keep "bad bank" Sareb ticking over.

Sareb was used to clean the balance sheets of state-rescued banks by taking on 50.7 billion euros worth of foreclosed properties and troubled loans to real estate developers.

The assets are matched by 50.7 billion euros in senior debt and backed by 4.8 billion euros in capital, more than half of which was contributed by Spain's healthy lenders to reduce the burden on state books.

The 8 percent capital cushion may however be too thin to withstand losses without a top-up, which could be hard to source from the private sector, said several senior Spanish bankers and investment bankers who have worked with the government.

"It was a big mistake. The government is going to have to take over the entire vehicle sooner or later," said a Spanish banking executive, on condition of anonymity, echoing a view from three other senior bankers.

Ireland went through the same exercise where it purchased bad debt from its banks at inflated prices. All this does is transfers losses to the taxpayers and lets the bankers off the hook for paying for the losses.

Spain took 41 billion euros of a 100-billion-euro European credit line to bail out its banks last year. The bill added the equivalent of 3.5 percent of gross domestic product to a deficit that was already higher than allowed under EU rules.

The bailout came after several failed government efforts to clean up the financial sector, crippled by more than 300 billion euros in bad loans after a housing bubble burst in 2008....

The starting point for cleaning up the financial sector is transparency. Specifically, disclosure on an ongoing basis of all current global asset, liability and off-balance sheet exposure details.

With this information, markets can assess the losses at each bank.

With this information, markets can exert discipline so that the losses are recognized upfront.

Fortunately, Spanish banks are designed to absorb these losses as they have both deposit insurance and access to central bank funding. As a result, the Spanish banks can continue to support the real economy during the years it takes to rebuild their book capital levels.

The real estate parked with Sareb was already written down by an average of 63.1 percent and the loans by 45.6 when the assets were transferred to the bad bank, but four bankers argued that further losses could still deplete its capital.

Of its loans, only 22 percent are considered "normal"; 34 percent are rated "substandard" and 45 percent "doubtful".

Most of the loans are linked to finished properties, for which it might be easier to find a buyer, but 4.3 percent are for unfinished developments and nearly 10 percent are for empty lots, for which there is little or no demand.

Nearly all of the foreclosed properties in its portfolio are empty, including apartment blocks far outside big cities. Only 6,000 of nearly 83,000 housing units have tenants...

The real estate probably should have been written down by at least 78% and this assumes that "normal" means the borrower is performing out of current income and not drawing down on savings.

Meanwhile, Sareb is just beginning to comb through its assets.

"This (structure) could be a problem if the vehicle starts making losses and needs more equity, something very likely to happen in our view once it reappraises its assets," JPMorgan analyst Jaime Becerril said in a recent note.

One source familiar with Sareb said it was aware of the risk it might need more capital, but believed "that would only happen under an extremely distressed economic scenario."

A stress test of Spanish banks last year by consultant Oliver Wyman, which served as the basis for some of Sareb's calculations, defined a worst case scenario as a 2.1 percent economic drop in 2013 and a 0.3 percent contraction in 2014.

JPMorgan's analyst will be shown as correct as so far no consultant has run a credible stress (hint: to be credible, the banks would disclose their exposure details so that market participants could confirm the results for themselves).

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.